Saturday, February 9, 2008

How does the Fed pump money into the economy?

We hear on CNBC and read in financial journals that the “Fed is pumping money into the economy”. What does this mean? Does it mean the Fed works overtime and prints lot of currency? No, it does not work that way.

The Federal Reserve (Fed) has 3 methods to influence its monetary policy
i) Raise/Lower short-term interest rates
ii) Raise/Lower the amount of reserves that banks are required to hold
iii) Open Market Transactions

Short-term Interest Rates
When the economy is softening (current state), a rate cut improves things – since it makes things cheaper. On the other hand, if the economy is too strong, an interest rate cut slows down the economy.

Reserves
If the Fed asks banks to raise their reserves, it means banks need to hold on to more money which in turn reduces the money supply and thus tightens credit. When the Fed asks banks to lower their reserves, there is more money that the banks can lend.

Open Market Transactions
Open market transactions are measures by which the Fed controls the money supply by buying and selling government securities, or other financial instruments. Of the three, Open Market transactions have the most immediate effect on the economy. If the Fed wants to squeeze money from the system, it sells bonds from its account. This deducts the amount from the dealer (bank) thus draining money from the system. On the other hand, if the Fed wants to “pump money into the economy”, it will buy bonds and pay the bank that sold them. This money then flows thru the system and that is how the Fed increases money supply.

The Fed has been buying a ton of subprime mortgage bonds (since there were virtually no buyers for it) in light of the subprime crisis.

2 comments:

Anonymous said...

Good article .
Along similar lines but slightly elaborate is this material published by Reserve Bank India. This is worth a read as the explanation is in very simple terms.

http://www.rbi.org.in/financialeducation/Basic.aspx

Shailendra

Manik Kinra said...

Good One! So when FED recently pumped money which of the 3 options did they choose. And are there any reasons behind choosing one over the others.